Nope, That’s Not What Went Wrong At The Ratings Agencies

There’s a hardening consensus around the idea that a key factor that lead to the current crisis was collusion between the issuers of mortgage securities and the ratings agencies to inflate ratings, fooling investors into thinking they were buying safe paper. This leads people to think that there’s an easy way out—simply ban issuers from paying for ratings and make buyers pay instead.

Unfortunately, this view is way too simplistic. In reality, the corruption of ratings is far more thorough than people think. And that corruption means that changing who pays the ratings agencies probably won’t do any good.

The poor performance of highly rated credit instruments, especially those tied to the subprime mortgage market, is great evidence that there was something deeply wrong with the ratings process. And the fact is that the business model of ratings agencies did change from the buy-side paying for ratings to the sell-side paying for ratings. While this may have contributed to the poor quality of ratings, the consensus view over-estimates the causation.

The truth is that the buy-side also wanted inflated credit ratings. It wasn’t just issuers pushing them, it was buyer demand pulling for them. Why would buyers want poor quality ratings? Because many fixed-income investors are constrained by regulations or bylaws in ways that make them desire highly-rated securities that have outsized yields. These regulations created a market demand for poor quality ratings.

Take, for example, a state pension fund required to invest in only triple-A rated credits. It would naturally be tempted toward the riskier side of the credit market in order to achieve higher returns while operating within its regulatory restrictions. The problem was not that the fund managers didn't understand the products were riskier but that they decided to engage in regulatory arbitrage.

Banks were also engaged in this regulatory arbitrage game. Particularly in Europe, Basel II risk-based capital requirements allowed them to set aside less capital when they bought highly rated debt securities. This allowed them to invest more of their capital while receiving higher returns.

Imagine, if you will, a fancy ball in which the guests were told they could wear only diamond jewelry, and were required to bring a certificate of authenticity from a jeweler. Obviously there would be a demand for the services of jewelers who were willing to call costume stones diamonds. That's what happened. The investors wanted to buy cheap baubles to the ball.

Over time, such this reg-arb dynamic starts feeding on itself. As pension fund managers, bank treasurers and corporate financial officers super-charge their returns with highly rated yet risky credit products, a straight-arrow investor who avoided this game would have found themselves underperforming the market. There’s a word for the kind of person: unemployed.

We know that investors were not fooled in the way the consensus view expects because prices on similarly rated credits based on very different asset types--say a triple A rated mortgage backed security and a triple A rated piece of general corporate indebtedness--weren't identical. Mortgage backed securities had lower prices and higher yields than less risky debt such as triple A corporates or government securities, regardless of the rating assigned. This demonstrates that players in this market understood that ratings were relative to the type of underlying debt.

Unfortunately, the divergence in pricing was not as great as it should have been. Those risky triple-A's were even riskier than their pricing implied, which is one reason the losses on these instruments came as such a surprise to the investors that bought and held them. There are strong indications, however, that these pricing errors were not market failures so much as additional regulatory failure.

The increased demand for risky-yet-highly-rated products would have depressed yields in the market, obscuring the information about risk from pricing. In short, a body of regulations that didn't fit well with market processes wound up distorting those market processes in a disastrous way.

The buyer demand for highly rated securities may be gone for now. But the underlying regulations are still in place, which means that the reg-arb play will return. And that, in turn, means that ratings agencies will still be pressured by investors into rating risky debt at close to riskless levels.